Demand and Supply:
How Markets Work
Lecture 1 – academic year 2014/15
Introduction to Economics
Fabio Landini

• The market: what is it?
• Demand: what changes the quantities demanded?
• Supply: what changes the quantities supplied?
• How do we explain changes in prices as a result of shifts in demand and supply?
2

Definition: “A market consists of a group of
buyers and sellers of a given good or service”
– Buyers determine the demand.
– Sellers determine the supply.
During the first part of the course we will focus mainly on markets for goods. However, the same reasoning hold also for factors of production (e.g. labour, capital).
3

Typologies of Markets
Perfect competition
• Many sellers and many buyers, each of them with no influence on market prices
• Goods are perfect substitute
Fruits market in Panajii - India
4

Typologies of Markets
Monopoly
• Only one seller that fix the price
5

Typologies of Markets
Oligopoly
• Few sellers, not always in competition with each other (cartels)
6

Typologies of Markets
Monopolistic competition
• Many sellers, tough competition, and product differentiation
7

The quantity demanded is the quantity that buyers want and can buy
8

The demand table contains information on the relationship between the price of a good and the quantity demanded.
The demand curve is a graph that shows the relationship between the price of a good and the quantity demanded.
9

Example: Demand of Ice-cream
Price Quantity
0.00
0.50
1.00
1.50
2.00
2.50
3.00
12
10
8
6
4
2
0
3.00
2.50
2.00
1.50
1.00
0.50
Price of ice-cream
0 1 2 3 4 5 6 7 8 9 10 11 12 Quantity of ice-cream
10

Example: Demand of Ice-cream
Price Quantity
0.00
0.50
1.00
1.50
2.00
2.50
3.00
12
10
8
6
4
2
0
3.00
2.50
2.00
1.50
1.00
0.50
Price of ice-cream
0 1 2 3 4 5 6 7 8 9 10 11 12 Quantity of ice-cream
11

Example: Demand of Ice-cream
Price Quantity
0.00
0.50
1.00
1.50
2.00
2.50
3.00
12
10
8
6
4
2
0
3.00
2.50
2.00
1.50
1.00
0.50
Price of ice-cream
0 1 2 3 4 5 6 7 8 9 10 11 12 Quantity of ice-cream
12

Law of the Demand
There exist an inverse
relationship between price and quantity demanded
3.00
2.50
2.00
1.50
1.00
Price of ice-cream
0.50
0 1 2 3 4 5 6 7 8 9 10 11 12 Quantity of ice-cream
13

What determines the quantity of ice-cream that is demanded ?
• Market price.
• Consumer’s income.
• Price of other goods.
• Consumer’s preferences.
• Consumer’s expectations.
14

Why does the quantity demanded vary?
The quantity demanded can vary for two reasons
• Movements along the demand curve: caused by a Δ in market prices;
• Shifts of the demand curve: caused by a Δ of the other determinants of demand (income, price of other goods, preferences, expectations).
15

Why does the quantity demanded vary?
Variables that affect the quantity demanded
Price
Income
A change of this variable induces…
Movement along the demand curve
Shift of the demand curve
Price of other goods Shift of the demand curve
Preferences Shift of the demand curve
Expectations Shift of the demand curve
Number of consumers Shift of the demand curve
16

Changes of the quantity demanded
17

Changes of the quantity demanded
Price of cigarettes
(a packet in euro)
4.00
2.00
0 12 20
D
1
Number of cigarettes smoked in a day
18

Changes of the quantity demanded
Price of cigarettes
(a packet in euro)
4.00
A tax on the production of tobacco increases the price of cigarettes. Therefore, it induces a movement along the demand curve.
2.00
0 12 20
D
1
Number of cigarettes smoked in a day
19

Changes of the quantity demanded
Price of cigarettes
(a packet in euro)
4.00
2.00
C
A tax on the production of tobacco increases the price of cigarettes. Therefore, it induces a movement along the demand curve.
A
0 12 20
D
1
Number of cigarettes smoked in a day
20

Changes of the quantity demanded
Price of cigarettes
(a packet in euro)
4.00
2.00
C
A tax on the production of tobacco increases the price of cigarettes. Therefore, it induces a movement along the demand curve.
A
0 12 20
D
1
Number of cigarettes smoked in a day
21

Shift of the Demand Curve
22

Shift of the Demand Curve
Price of cigarettes
(a packet in euro)
4.00
2.00
0 10 20
D
1
Number of cigarettes smoked in a day
23

Shift of the Demand Curve
Price of cigarettes
(a packet in euro)
4.00
A public provision aimed at discouraging smoking induces a leftward shift in the demand curve.
2.00
0 10 20
D
1
Number of cigarettes smoked in a day
24

Shift of the Demand Curve
Price of cigarettes
(a packet in euro)
4.00
A public provision aimed at discouraging smoking induces a leftward shift in the demand curve.
2.00
0 10
D
2
20
D
1
Number of cigarettes smoked in a day
25

2.00
Shift of the Demand Curve
Price of cigarettes
(a packet in euro)
4.00
0 10
B
A public provision aimed at discouraging smoking induces a leftward shift in the demand curve.
A
D
2
20
D
1
Number of cigarettes smoked in a day
26

What about a change in income?
Price of cigarettes
(a packet in euro)
4.00
2.00
0 10 20
D
1
30 Number of cigarettes smoked in a day
27

What about a change in income?
Price of cigarettes
(a packet in euro)
4.00
2.00
0 10 20
D
2
D
1
30 Number of cigarettes smoked in a day
28

What about a change in income?
Price of cigarettes
(a packet in euro)
4.00
2.00
0 10 20
D
2
D
1
30 Number of cigarettes smoked in a day
29

What about a change in income?
Price of
Ice-ream
(a cone in euro)
4.00
2.00
0 1 2
D
2
D
1
3 Number of cigarettes smoked in a day
30

What about a change in income?
Price of
Ice-ream
(a cone in euro)
4.00
For a normal good, an increase in income increases the quantity demanded
2.00
0 1 2
D
2
D
1
3 Number of cigarettes smoked in a day
31

When a decrease in the price of one good causes a decrease in the quantity demanded of another good, the two goods are called
substitute (e.g. tea and coffee).
32

When a decrease in the price of one good causes an increase in the quantity demanded of another good, the two goods are called
complementary(e.g. PCs and High-speed
Internet access).
33

Example: what shifts the demand of a Toshiba PC?
How does the demand of a Toshiba personal computer (PC) shift if:
• Consumers’ income decrease;
• The price of a Compaq PC decreases;
• The price of high-speed Internet connection reduces;
• The use of Internet across households increases;
34

Price of ice-cream
3.00
2.50
2.00
1.50
1.00
0.50
From Individual Demand…
Caterina’s demand
Nicola’s Demand
Price of ice-cream
3.00
2.50
2.00
1.50
1.00
0.50
0 1 2 3 4 5 6 7 8 9 10 1112 Quantity of
Ice-cream
0 1 2 3 4 5 6 7 8 9 10 1112 Quantity of
Ice-cream
35

…. To Market Demand
Price of ice-cream
3.00
2.50
2.00
1.50
1.00
0.50
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19
( = 4 + 3)
Quantity of
Ice-cream
36

The quantity supplied is the quantity that sellers want and can sell
37

• Market prices
• Cost of factors of production
• Technology
• Expectations
38

Law of the Supply: the quantity supplied of a given good increases with the price.
Why? Because, for given costs of production and commercialization, an increase in price generates greater revenues (all costs being equal) and thus it induces sellers to increase production.
39

The supply table is a table that contains information on the relationship between the price of a good and the quantity supplied
The supply curve is a graph that shows the relationship between the price of a good and the quantity supplied
40

Supply Curve
Price Quantity
0.00
0.50
1.00
1.50
2.00
2.50
3.00
0
0
1
2
3
4
5
Price of ice-cream
3.00
2.50
2.00
1.50
1.00
0.50
0 1 2 3 4 5 6
Quantity

Supply Curve
Price Quantity
0.00
0.50
1.00
1.50
2.00
2.50
3.00
0
0
1
2
3
4
5
Price of ice-cream
3.00
2.50
2.00
1.50
1.00
0.50
0 1 2 3 4 5 6
Quantity

Supply Curve
Price Quantity
0.00
0.50
1.00
1.50
2.00
2.50
3.00
0
0
1
2
3
4
5
Price of ice-cream
3.00
2.50
2.00
1.50
1.00
0.50
0 1 2 3 4 5 6
Quantity

Why does the quantity supplied vary?
The quantity supplied can vary for two reasons:
• Movements along the supply curve, caused by a
Δ in market prices;
• Shifts of the supply curve, caused by a Δ of the other determinants of supply (technology, cost of factors of production, expectations)
44

Why does the quantity supplied vary?
Variables that affect the quantity supplied
Market price
Price of the factors of production
Technology
Expectations
Number of sellers
A cha nge of this va riable induces…
Movements along the supply curve
Shifts of the supply curve
Shifts of the supply curve
Shifts of the supply curve
Shifts of the supply curve
45

Increase of Supply
46

Price of ice-cream
Increase of Supply
S
1
0 Quantity

Price of ice-cream
Increase of Supply
S
1
S
2
Increase of supply
0 Quantity

Price of ice-cream
Increase of Supply
S
1
0 Quantity

Price of ice-cream
Increase of Supply
S
3
Decrease of supply
S
1
0 Quantity

Example: what shifts the supply of a
Toshiba PC
How does the supply of a Toshiba personal computer
(PC) shift if:
• The price of semi-conductors increases;
• Toshiba re-organize her production lines to improve efficiency;
• Toshiba’s managers expects a decrease in the price of semi-conductors in the future;
51

• Every market has two sides: demand and supply
• The main determinants of demand are the price of the good, consumer’s income, the price of other goods, consumer’s preferences and expectations
• The main determinants of supply are the price of the good, costs of production, technology and expectations
52

Equilibrium of Demand and Supply
Equilibrium Price
Is the price for which demand equals supply.
Graphically, it is the price for which the demand curve and the supply curve intersect.
53

Equilibrium of Demand and Supply
Equilibrium Quantity
Is the quantity for which demand equals supply.
Graphically, it is the quantity for which the demand curve and the supply curve intersect.
54

Equilibrium of Demand and Supply
Price of ice-cream
Supply
2.00
Demand
0 1 2 3 4 5 6 7 8 9 10 11 12 13 Quantity of
Ice-cream 55

Equilibrium of Demand and Supply
Price of ice-cream
Supply
Equilibrium
2.00
Demand
0 1 2 3 4 5 6 7 8 9 10 11 12 13 Quantity of
Ice-cream 56

Equilibrium of Demand and Supply
Price of ice-cream
2.00
Equilibrium price
Supply
Equilibrium
Demand
Equilibrium quantity
0 1 2 3 4 5 6 7 8 9 10 11 12 13 Quantity of
Ice-cream 57

Excess supply
• Price is greater then its equilibrium level
• Sellers cannot sell the quantity they want at that price
Excess demand
• Price is lower then its equilibrium level
• Buyers cannot buy the quantity they want at that price
58

Excess Supply
Price of ice-cream
Excess Supply
Supply
2.50
2.00
0 4
Quantity demanded
7 10
Quantity supplied
Demand
Quantity of
Ice-cream
59

Excess Supply
Price of ice-cream
Supply
2.00
1.50
0
Excess Demand
4
Quantity supplied
7 10
Quantity demanded
Demand
Quantity of
Ice-cream
60

External events alter the market equilibrium.
How do we study the determination of the new equilibrium?
We have three things to do:
• To understand if the external event causes shifts in the demand curve and/or the supply curve
• To understand in which direction the demand shift.
• To understand if the shift affects the equilibrium prices and quantities, and how the new equilibrium is achieved.
61

Equilibrium effects of an increase in demand
Price of ice-cream
S
1
2.00
0 7
Initial
Equilibrium
D
1
Quantity of
Ice-cream 62

Equilibrium effects of an increase in demand
Price of ice-cream
1. Nice weather causes an increase in the demand of ice-cream
S
1
2.00
0 7
Initial
Equilibrium
D
1
Quantity of
Ice-cream 63

Equilibrium effects of an increase in demand
Price of ice-cream
1. Nice weather causes an increase in the demand of ice-cream
S
1
New Equilibrium
2.50
2.00
Initial
Equilibrium
D
2
D
1
0 7 10
Quantity of
Ice-cream 64

Equilibrium effects of an increase in demand
Price of ice-cream
1. Nice weather causes an increase in the demand of ice-cream
S
1
New Equilibrium
2….that causes an increase in prices…
2.50
2.00
0 7 10
3….and an increase in the quantity that is sold…
Initial
Equilibrium
D
1
D
2
Quantity of
Ice-cream 65

How do we move from the old to the new equilibrium?
We saw that nice weather causes a shift in the equilibrium. We haven’t yet explained how this happens.
To do so, we use the concept of excess demand.
If the demand increases, the quantity demanded is greater than the quantity supplied at the initial price.
Market prices will tend to increase.
66

How do we move from the old to the new equilibrium?
When the price increases, two things happen:
• The quantity supplied increases (Law of the
Supply)
• The quantity demanded reduces (Law of
Demand)
Results: the initial excess demand reduces gradually, until in the new equilibrium it is equal zero.
67

The combination of demand and supply determines the price of the goods (and services) available in the market.
Prices are the signals (information) that address the allocation of (scarce) resources and ensure the achievement of the market equilibrium.
68

We will start to look at some properties of demand and supply…. In particular,
elasticity…
69